In the last decades the world economy has seen firms organise production into global value chains, decentralise their systems of command to incentivise workers, and start compensating CEOs with skyrocketing earnings. This column uses new data on German and Austrian firms to show that managerial offshoring to eastern Europe has increased decentralised management by 6.8% in relatively open sectors, but it has lowered the relative wages of executives in Germany and Austria by 4.9%.

In the last three decades, the world economy has been characterised by several new features. First, firms have organised production in international value chains to cut costs. According to an estimate, international value chains, or 'trade in tasks', account for a third of the increase in world trade since 1970 and intra-firm imports account for between 22% to 69% of total imports between western and eastern Europe (Hummels et al. 2001, Marin 2006).1

Second, firms have decentralised their system of command in flatter corporate hierarchies to incentivise workers. Rajan and Wulf (2006), Marin (2008) and Marin and Verdier (2014) document that firms in the US, Germany, and Austria shifted to a more decentralised organisation over time. Bloom et al. (2010) show that firms in the US and northern Europe have the most decentralised organisation, while firms in Asian countries are most centralised.2

Third, firms have started to compensate their CEOs with skyrocketing earnings. CEO compensation increased sixfold from 1980 to 2005 in the US, and 3.5-fold from 1977 to 2008 in Germany (Frydman and Saks 2010, Fabbri and Marin 2016).

In this column, we ask whether offshoring and 'trade in tasks' have been the driving forces behind these observed changes in the corporation. We incorporate 'trade in tasks' à la Grossman and Rossi-Hansberg (2008) into a small open economy version of Marin and Verdier (2012) to explore how offshoring of production tasks and managerial tasks affect the internal organisation of firms and CEO pay in rich countries. We gain several insights from merging these two models.

First, we show that the offshoring of production tasks by firms in rich open economies to low-wage countries unambiguously increases firms' profits, and thereby induces firms to reorganise to decentralised management in which power is allocated to the skilled manager in firms in rich countries. Profits rise, because offshoring firms become more productive which allows them to gain market shares from foreign rivals. When profits rise, principals in firms in rich countries start to monitor more inside the firm, potentially destroying the initiative of their skilled managers. Firms decentralise power to the skilled manager to keep her initiative alive.

The improved competitiveness of firms in rich countries as a result of offshoring has been an important argument in the empirical literature on the labour market effects of offshoring. This literature argues that offshoring to low wage countries has not led to major job losses in rich countries, because it has helped firms to gain market shares increasing the demand for labour in rich countries. Improved competitiveness as a result of offshoring has so far not been shown in the literature, neither theoretically nor empirically.3

New evidence

We test the prediction of the model based on original firm-level data we designed and collected from 660 Austrian and German multinational firms with 2200 subsidiaries in Eastern Europe.

We find that:

Offshoring firms are 22.3% more decentralised than non-offshoring firms when we exploit variation in the relative industry wages and the road distance between parent and affiliate firms to instrument for trade in tasks; and

Offshoring of skilled managers to low wage countries has an ambiguous effect on CEO wages and the organisation of firms in rich countries.

On the one hand, offshoring of managerial tasks lowers the demand for managers in rich countries which relaxes the resource constraint on managers, lowering their relative wages (the labour market effect). On the other hand, the lower start-up costs of a firm (each firm hires a manager to start a firm) induce firm entry into the market, which increases competition and raises the demand for managers, resulting in a rise in the relative wage of managers (the 'war for talent' effect). When the economy is sufficiently open to international trade, the 'war for talent' effect dominates the labour market effect, making it more likely that firms in rich countries decentralise management and pay their CEOs higher wages.

Concluding remarks

We show, with unique data on German and Austrian firms, that managerial offshoring to eastern Europe has occurred frequently and has been substantial. German and Austrian multinational firms offshored managers in 57% of foreign direct investment to eastern Europe, with on average 2.63 managers offshored per investment project. We find that an increase in the fraction of managers offshored by the sample mean reduces the level of decentralised management by 3.4%, but increases decentralised management by 6.8% in sectors with a level of openness above the 25th percentile of the openness distribution. Lastly, we find that one additional offshored manager on average lowers the relative wages of executives in Germany and Austria by 4.9%, with the labour market effect reducing CEO wages relative to workers by 6.9% and the 'war for talent' effect increasing CEO relative wages by 2%. The large estimated labour market effect of managerial offshoring may explain why the rise in CEO compensation in Germany has been less pronounced than in the US. We estimate that managerial offshoring has contributed to lowering CEO wages in Germany by 18%. The results suggest that CEOs operate in a tight labour market giving them large rents.